Blain's Morning Porridge - August 31st 2017. The big risk? The ECB taper... what follows?

Blain’s Morning Porridge – August 31th 2017

“It will not always be summer; build barns.”

For the avoidance of doubt – the Morning Porridge is market commentary, it is not investment advice…

Today’s sermon is about complacency.

Yesterday, I read in a Fixed Income analyst comment something about the: “robust macro backdrop ahead of the ECB meeting on Sept 7th creating a solid base for risk assets and prompting a steady flow of borrowers to get funding programmes underway..”

Sure enough, there is a feeding frenzy developing in the new issue bond market...

Meanwhile, my stock picking chartist Steve Previs warns the gauges he follows, like put/call ratios and VIX, reflect an “overly confident” market. He thinks a top is coming.

Personally, I’ve still got October 12th at 10.30 in the morning tagged as the moment the big equity crash occurs and I get out my buying boots ready for the opportunities that will follow. (Why Oct 12th? Why not..? The date has a nice ring about it as day of manic market mayhem – and the following day is a Friday the 13th… meaning it will panic folk even more!” Mwwwhahahaha..! )

In the fixed income markets I think we’re glossing over the likely pain to come courtesy of the ECB.

What happens post the next ECB meeting, (or more likely the ECB meeting after that, or the one after that, based on the ECB’s predilection for kicking the can down the road)? Forget inflation and growth nonsense.. at some stage the ECB has no choice but to ‘fess up how it’s actually been mutualising European debt, and cut its buying programme. We’re all talking about European normalisation, wondering when, but when it actually happens, please explain exactly how that “solid base for risk assets” works.

If I was wearing a corporate treasurer hat then I can understand exactly why I would want to fund today – rates are still cheap. If I have to wait until the ECB announces its scaling back its buy programmes then I’m potentially in trouble. At that point, which confirms the ECB is no longer the buyer of unlimited recourse, debt levels have got to rise. It will be “interesting” is the way a slo-mo misted-red battle scene from GoT is “interesting”..

Why so gory?

Scaling back (tapering) QE in the US didn’t cause the bond market to crumble and collapse.

That’s because the US market is very different to Europe. It’s a single political polity under the dollar god and functions as such. It has functional financial markets and banks. (Compare and contrast European banks…) US QE functioned pretty much as stated on the box – it pumped money into the economy to be recycled into credit lending via a banking system that had gone through a crash-course recovery programme. (The fact much of that lending was then arbitraged by smart CFOs into share-buy-back programmes is a mere detail and a bedtime story for another day…)

Europe is very different.

The ECB is herding a menagerie of European nations with different goals, ambitions, (and most importantly) varied attitudes to debt. They are all using the wrong and very unsuitable currency – the compromise that fits none known as the Euro. None of the sovereign issuers retains access to the printing presses. The banking system is “mixed” – still very much broken in the South.

It’s been the illusion the ECB will keep buying that has kept folk buying in its wake, thus keeping rates artificially low– solely on the basis buyers couldn’t lose money if the ECB was there. (The fact the current European treaties didn’t perceive the ECB ever having to be there is just one aspect of the monumental cluster***k of compromises at the core of the Euro. Harsh… I know I shouldn’t be swearing this early in the morning… but.. sometimes it just makes you feel good.)

When the ECB stops buying – so will the smart money.

If Europe was fixed, it might be another story. But, at present there is no conceivable explanation of how countries like Italy can fund at such absurdly low interest rates – its 10-yr debt trades a mere 180 points higher than Germany. You are about to scream at Italy isn’t about to go bust or default. Of course it’s not – not as long as the last fool keeps investing on the coat-tails of the ECB. And Italy is not going to go bust right up until the moment it does. Which, again, will likely be sooner than you think. Why? Because it’s got loads more debt than it can realistically afford, it doesn’t hold the keys to the printing presses, and there is dodgy political wind blowing from the North..

Remember. Italy is not a sovereign credit. It is a polity without a currency, therefore borrowing in someone else’s currency. It doesn’t have the option to competitively devalue to compete. All it can do is devalue via austerity and contraction – which the Italians have utterly rejected with a dismissive smirk. They know austerity really doesn’t work very well. Just ask the Greeks.

But… Europe is not going to collapse in the wake of the ECB ending QE.

As soon as all the negativity I describe above becomes all-too-apparent I confidently predict the ECB will say something profound about “doing whatever it takes”, magicing up a new “give-banks-as-much-liquidity-as-it-takes-for-them-to-buy-all-European-Sovereign-Bonds” programme, (call its something snappy like LTRWNASB (Long-term repos with new added sparkly bling)), Jens is yer uncle and everything fixed again until we realise just how broken it is..

QE was a continuation of the great ongoing European money trick – “do whatever it takes” – following on from giving European banks money so they don’t go bust and spending that money on European bonds.

The fact Europe seems to be in some long awaited recovery is due to cyclical forces and luck rather than the success of QE. So expect the current QE to be tapered and quickly and quietly replaced with something equally manipulative.

All of which beg’s the question.. if Europe is so bust.. where do I invest? First, its probably wise not to panic about Europe (secure in the knowledge the ECB won’t let it implode), but do you really want to invest in an illusion?

Probably not.

Its time to look East and West methinks.. Lots of interesting things happening in the US and Asia.. Lets see what the US numbers say tomorrow..

No Porridge tomorrow.. spending quality time with the medical professionals for an MOT.

Bill Blain